Top Tabs

Friday, October 14, 2016

Flashboys

Flash Boys got such rave reviews that I expected it to disappoint. It did not.

I didn't love Lewis' other books, which also had rave reviews, which is why I figured this one would fit the same pattern. But it got recommended to me enough times that I finally bit the bullet, and I'm glad I did. Lewis did an absolutely fantastic job discussing the subject of high frequency trading.

Lewis doesn't just talk about the state of the industry today, but delves into the history of why things are the way they are. A repetitive cycle of bad behaviour followed by regulations that try to correct for that behaviour followed by behaviour that exploits the regulations followed by more regulations seems to be leading us to an ever-more complex legal code that some groups will always be able to exploit.

I have to give credit to many of the high frequency traders, though. They innovated in order to exploit opportunities they were presented with, including placing their servers near exchanges and laying their own fiber when the telecom networks were routing them on inefficient, unreliable connections. Though it's sad that smart, motivated people are innovating in ways that add no value to society, they are hardly alone in that regard.

I had no idea there were 40+ exchanges in the US all trading the same stocks; this structure definitely creates an environment where high frequency firms can quickly arbitrage orders among exchanges and thereby profit from front-running slower traders.

It strikes me that some of the code out there (i.e. programmed robots out there buying/selling shares) is so complex that there are bound to be some huge bugs that cause market anomalies. I suppose we've already seen evidence of that during the so-called Flash Crashes, and we may see more!

I thought Lewis did take it a little easy on regular traders, though. It is the speculators' behaviours that really allow front-runners to thrive, because they trade so often and because they do weird things when they trade, but Lewis didn't touch on this. For example, investor holding periods are ridiculously low nowadays, and the more one trades the more one creates a market for those who profit on trading volume.

It is also the market convention that large positions are liquidated quietly that allows this underground business to thrive. The idea is that a public order could lower market prices, so sellers want their brokers to slowly and quietly sell large blocks of stock. But this also invites abuse. Imagine trying to sell your house by telling no one but your broker; you can expect brokers and the other intermediaries with whom they interact to benefit financially from the information advantage.

It also seems to me that an investor can protect himself to some extent from high frequency traders just by using limit orders. The prices on market orders can rise, allowing high frequency firms to buy ahead of the real buyer and sell the shares back to him. But on limit orders, the investor doesn't have to pay above the current ask, so if a fast trader buys up shares in advance on the statistical expectation that more shares will be requested even as the price rises, he could end up losing money as he then has to unload his purchased shares back into the market.

Flash Boys gave me a much better idea of the inner workings of the stock market and I highly recommend it to all investors.